The need for effective financial management

Andrew Otterburn warns that the LCD's proposed reforms mean firms dealing with legally aided cases can no longer afford to have lax accounting practices. Andrew Otterburn is a management consultant and editor of a new guide, Cash Flow and improved Financial Management, to be published by the Law Society in May.

The proposed extension of conditional fees will necessitate improved financial management and control, if firms are to successfully operate under the new regime envisaged by the Lord Chancellor's Department.

Many of the rules that have governed cash flow and financial management will change, in an area that, for many firms, represents a significant proportion of business.

It is a scenario that many would recognise. Picture a firm, typical of many, with five partners and a further four or five fee earners.

At £45,000 per partner, profit shares are near the average for firms of its size and it operates on an overdraft that fluctuates between £25,000 and its limit of £50,000.

Approximately half the firm's £800,000 fees are billed by the litigation department and three quarters of this work is legally aided – split equally between family, crime and personal injury. The fee earners have targets and are urged to bill regularly, but "personal financial discipline" is lax for the following reasons:

only some fee earners complete time sheets – the domestic conveyancers have always refused to do so;

few fee earners send interim or on-account bills – except where the matter is particularly large and is going to run for some time. The other exception is where a matter is legally aided where, because the firm has a franchise, fee earners are able to bill at six monthly intervals, and generally do so;

disbursements are rarely asked for as the matter proceeds, unless they are getting particularly high, and at any one time at least £75,000 is tied up in disbursements. The exception, once again, is legally aided work where the fee earners are good at obtaining reimbursement immediately; and

cash collection is poor. The firm has a credit control system, but it has never been taken seriously. Clients are rarely chased because the partners are generally wary about upsetting them and, in any case, the cashier is too busy. He has little time or inclination to make potentially embarrassing telephone calls – which he does not think he should have to make anyway. He believes it is the fee earner's job to make sure the firm gets paid, even though the firm's debtors generally run at about five months billing.

Within this hypothesis, overall financial management is also not particularly strong.

The cashier produces a budget and management accounts are published monthly, but the partners do not spend long looking at them.

They have little real idea of the profitability of the different departments and only a vague idea of their work in progress. Little input on financial management has been provided by – or asked of – the firm's accountants and, because the overdraft is not unduly high, the bank has never pressed the partners for more information on the firm's finances.

Many partners will recognise this scenario as not untypical – a reasonably successful firm that has not yet come under serious pressure.

Profits are lower than they would have been 10 years ago and there is much more competition, but overall, the firm is surviving.

However, a year hence, this could be a potentially different scenario.

If the Lord Chancellor's proposals concerning legal aid are introduced as they are presently envisaged, this firm could soon face a very different financial situation that will have an impact on all of its fee earners – contentious and non-contentious alike.

Approximately £100,000 of the firm's fees are accounted for by non-medical negligence personal injury – a mixture of road traffic accidents, accidents at work and some deafness work.

Although it is generally successful in these cases and costs are eventually paid by the other side's insurance company, the cases are at present funded during their life by the Legal Aid Board.

Because most cases take between 18 months and two years to settle, the firm's work in progress at any one time comprises more than a year's costs – the cashier has estimated the sum to be approximately £125,000 – and the disbursements in respect of these cases would be about the same.

Although some clients may fund their disbursements through a disbursement funding scheme, some will not, and these schemes do not fund the firm's costs.

There will be a need, gradually over the coming two years, to fund a growing amount of work – a level that is going to be hard to explain to the bank.

For many firms this new scenario will require greatly improved financial and overall management to survive. Certain key areas will need attention. In particular firms will need to:

be able to assess the relative profitability of different areas of work, and the amount of working capital which is tied up through work in progress, unbilled disbursements and debtors;

introduce simple and clear systems in respect of their litigation departments, in order to monitor how much of their work is legally aided and how much is done under conditional fee agreements;

learn how to assess and monitor risk;

consider appointing a practice manager or accountant to administer these controls and systems; and

put a much greater emphasis on minimising the working capital tied up in all areas of the firm.

This final point can be addressed on three fronts:

everyone will need to keep time sheets – how else can work in progress be monitored?

all fee earners will need to become better at billing disbursements as incurred and at raising on account bills where they are able to do so; and

fee earners will have be tougher on cash collection and appreciate that credit control starts at the first interview with the client, that many clients prefer regular small bills rather than one large bill at the end of the case, and that a client who does not pay, or is very slow, is of limited value.

Firms have always needed these types of financial checks and controls, but the need for them in the future is going to be much greater.

They need them for the benefit of their bank, for their staff and for themselves, because without them they are going to find it much harder to survive.